Economics and Politics of European Integration

1
Economics and Politics of European Integration

• Mika Widgrén
• Turku School of Economics and Business
  Administration, CEPR, CESifo and ETLA

2
Course Material

• Core reading
• Baldwin, R. Wyplosz, C. (2004) The Economics
  of European Integration, McGraw-Hill.
• Lectures
• Selected articles
• Others
• Widgrén, M. (2001) Euroopan integraation talous
  ja politiikka, Taloustieto.
• Hansen Nielsen (1997) An Economic Analysis of
  the EU, McGraw-Hill.
• De Grauwe, P. (2000) Economics of the Monetary
  Union, Oxford University Press.
• Some other articles

3
Rough Table of Contents

• Brief history of European post-war integration
• Institutions and decision making
• Microeconomics of European integration
• 3.1 Trade, pro-competitive effect
• 3.2 Growth and economic geography
• 3.3 The EU and the RoW
• Macroeconomics of European integration
• 4.1 Monetary integration
• 4.2 Fiscal policy in a monetary union

4
1. History
5
Early Post War Period

• A Climate for Radical Change

6
The prime question

• How can Europe avoid another war?
• What caused the war? 3 answers
• Blame the the loser
• Capitalism
• Destructive nationalism
• These implied 3 post-war solutions
• Neuter Germany , Morgenthau Plan, 1944
• Adopt communism
• Pursue European integration
• European integration ultimately prevailed, but
  this was far from clear in the late 1940s.

7
First Steps

• First Steps the OEEC, EPU, Council of Europe
• OEEC and EPU (1950-58) set up in conjunction with
  Marshall Plan
• OEEC coordinated aid distribution and prompted
  trade liberalisation (OECD after 1961)
• EPU facilitated payments and fostered
  liberalisation
• Council of Europe 1949

8
European Coal and Steel Community

• Treaty of Paris 1951, the Six signed the Treaty
• Background
• To make war materially impossible war industries
  were put under shared supranational authority
• Excess capacity
• Followed by a plan of political union 1954

9
Two strands of European integration

• Federalism and intergovernmentalism
• Immediate disagreement about depth of European
  integration
• Federalism supranational institutions
• Intergovernmentalism nations retain all
  sovereignty
• Intergovernmental initiatives
• OEEC (1948), Council of Europe (1949), EFTA
  (1960)
• Federal initiative
• ECSC (1951), EEC (1958)

10
The Treaty of Rome 1957

• Established the European Economic Community, EEC
  (and Euratom)
• Customs Union, common external trade policy
• Common agricultural policy
• Idea common markets
• to lay foundations of ever closer union
• Note the Fusion Treaty (1965) integrated ECSC,
  EEC and Euratom into the EC

11
European Free Trade Area

• Stockholm Convention 1959
• Outer seven, i.e. the UK, Denmark, Norway,
  Sweden, Switzerland, Austria and portugal
• Finland signed got an associate status 1960
• The role of EFTA was two-fold
• Counter-force, better bargaining position
• Bridge-building
• However
• The UK, Denmark, Ireland and Norway applied for
  EEC membership during 1961-62

12
1960-1973, two non-overlapping circles
13
Luxembourg Compromise

• Disagreement on majority voting early 1966
• France started to pursue empty chair policy
• Agreement in March 1966
• Right to claim for unanimity whenever important
  national preferences are threatened by majority
  voting
• Note no official legal status, not a part of the
  Union Treaty

14
Evolution to Two Concentric Circles

• First enlargement, 1973
• UK, Denmark, Ireland Norway admitted
  (Norwegians say no in referendum)
• Enlargement of EEC reinforces force for
  inclusion on remaining EFTAs
• Remaining EFTAs sign FTA agreements with EEC-9
• Why werent the FTAs signed before?
• Domino-like affect of lowering barriers
• 1st within EEC6 ? enlargement ? EEC-EFTA FTAs

15
Two concentric circles
16
Euro-pessimism, 1975-1986

• Political shocks
• Luxembourg Compromise
• Failure of Monetary Integration (Werner Plan
  1971)
• Failure of Deeper Trade Integration
• Growing cost of Common Agricultural Policy
  creates frictions over budget

17
Bright spots

• Democracy in Spain, Portugal and Greece
• Greece joins in 1981
• Spain and Portugal join in 1986 after long a
  difficult accession talks
• EMS set up in 1979 works well
• Budget Treaties
• European Parliament 1979

18
Deeper circles single market programme

• Delors launches completion of the internal market
  with Single European Act
• create "an area without internal frontiers in
  which the free movement of goods, persons,
  services and capital is ensured".
• Important institutional changes, especially move
  to majority voting on Single Market issues

19
Single Market Programme, EC92

• Basic elements
• Goods Trade Liberalisation
• Streamlining or elimination of border
  formalities,
• Harmonisation of VAT rates within wide bands
• Liberalisation of government procurement
• Harmonisation and mutual recognition of technical
  standards in production, packaging and marketing
• Factor Trade Liberalisation
• Removal of all capital controls (!!!), and deeper
  capital market integration
• Liberalisation of cross-border market-entry
  policies,

20
Domino effect, part II

• Deeper integration in EC-12 strengthened the
  force for inclusion in remaining EFTAns
• End of Cold War loosened EFTAns resistance to EC
  membership
• Result of force for inclusion
• EEA initiative to extend single market to EFTA
  (Delors 1989)
• Membership applications by all EFTAns except
  Iceland
• Concentric circles, but both deeper

21
EU-EFTA Integration in the 1980s

• Luxembourg Declaration 1984 defined the broad
  guidelines
• Interlaken Principles 1987
• Community first
• Autonomy of EU decision making
• EEA negotiations 1990-92, but
• Influence deficit

22
Fourth enlargement

• 1994, Austria, Finland, Norway and Sweden
  admitted (Norwegians again vote no).

1994
1973
2004
1958
Cyprus
1973
Malta
1981
23
USSR collapses

• 1991, Estonia, Latvia and Lithuania declared
  their independence from the USSR
• End of 1991, the Soviet Union itself breaks up
• Cold War ends without a shot
• Military division of Europe ended

24
EU reacts

• The European Union reacted swiftly to this
  geopolitical earthquake by providing emergency
  aid and loans to the fledgling democracies.
• Signing of Europe Agreements with newly free
  nations in Central and Eastern Europe
• These are free trade agreements with promises of
  deeper integration and some aid

25
From Copenhagen to Copenhagen

• EU says CEECs can join the EU (June 1993)
• Set out famous Copenhagen criteria for membership
• stability of institutions guaranteeing democracy,
  
• the rule of law,
• human rights and respect for and, protection of
  minorities,
• the existence of a functioning market economy as
  well as the capacity to cope with competitive
  pressure and market forces within the Union
• Copenhagen summit December 2002
• 10 CEECs can join in 2004

26
Blankart Kirchner (2004) The deadlock of EU
budget an economic analysis of ways in and ways
out, in Blankart Mueller, eds., A Constitution
for the European Union, MIT Press.
27
German unification and Maastricht

• Jacques Delors proposes radical increase in
  European economic integration
• the formation of a monetary union
• Idea championed by French President Francois
  Mitterrand and German Chancellor Helmut Kohl.
• Grand deal? German can unify if it gives up the
  DM
• Maastricht Treaty, signed 1992
• a monetary union by 1999, single currency by
  2002.
• Also, sets up EUs three pillar structure
• ERM exchange rate crises

28
Preparing for Eastern Enlargement

• Impending enlargement required EU to reform its
  institutions
• Three tries
• Amsterdam Treaty, 1997
• Nice treaty, 2000
• draft Constitutional Treaty, 2003
• Reconsidered by IGC 2003
• Political decision on the Constitutional Treaty
  in June 2004

29
Amsterdam Treaty

• Failed to reform main institutions
• Tidied up of the Maastricht Treaty
• More social policy, Parliament powers modestly
  boosted,
• flexible integration, closer cooperation
  introduced
• Amsterdam leftovers
• voting rules in the Council of Ministers,
• number of Commissioners,
• Extension of issues covered by majority voting

30
Nice Treaty

• Reforms of main institutions agreed, but poorly
  done
• Council voting rules highly complex and reduce
  EUs ability to act with more members
• No important extension of majority voting
• Make shift solution for Commissioners
• No reform of decision making in ECB
• Generally viewed as a failure
• Main changes re-visited in draft Constitutional
  Treaty 2003 and Constitutional Treaty 2004

31
Main Types of Economic Integration

• FTA no internal trade barriers
• CU FTAcommon external trade policy
• Single Market CUno invisible trade barriers
• Common Market SMfree mobility of factors
• Monetary Union CMcommon currency
• Economic Union Monetary Union common economic
  policy

32
Domino Effect (I)
b
a
e
f
AC
g
h
RD
d
c
MC
RD
MR
MR
33
Domino Effect II
Costs/benefits
RR
EE
EE
Membership
Domino effect expands membership
34
Demand and Supply of Membership
Price differential
Supply
a
deepening
c
a
b
Demand
Membership
widening
35
Empirical Evidence on the Domino Effect

• Sapir (1997)
• Estimates a gravity equation of bilateral trade
  flows for 1960-92
• Adds regional integration dummies
• EFTA membership becomes a burden after 1975
  (upper bound of 5 confidence intervals in 1988)
• EU-EFTA integration becomes is a burden
  throughout the estimation period (upper bound ion
  1986)

36
2. Institutions and Decision Making
37
Law Sources of EU Law

• The EU Court created by the Treaty of Rome
• Court then established the Communitys legal
  system.
• EC law was established on the basis of
• The EU institutions ensuring that actions by the
  EC take account of all members interests, i.e.
  the Communitys interest
• The transfer of national power to the Community.
• Source Borchardt (1999 p.24)
• Draft Constitutional Treaty may replace this as
  the source of EU law

38
Law Key principles of EC Law

• 1. Autonomy
• system is independent of members legal orders.
• 2. Direct Applicability
• has the force of law in member states so that
  Community law can be fully and uniformly
  applicable throughout the EU.
• 3. Primacy of Community law
• Community law has the final say e.g. highest
  French court can be overruled on a matters
  pertaining to intra-EC imports.
• Necessary so Community law cannot be altered by
  national, regional or local laws in any member
  state.

39
Law Structure

• The EUs 3-Pillar Structure
• What is the difference between the European
  Community and the European Union?
• 3 Pillar Structure
• 1st Economics
• 2nd Security Foreign
• 3rd Justice
• EC law only applies to 1st pillar.
• EU is roof over the three pillars

40
Law Types of EU legislation

• Primary legislation
• Treaties
• Secondary legislation
• collection of decisions made by EU institutions
• 5 types of secondary law
• 1. regulation
• applies to all member states, companies,
  authorities and citizens. Regulations apply as
  they are written, i.e., they are not transposed
  into other laws or provisions. They apply
  immediately upon coming into force.

41
Law Types of EU legislation

• 2. directive
• may apply to any number of member states, but
  they only set out the result to be achieved.
• member states what needs to be done to comply
  with the conditions set out in the directive
  (e.g. new legislation, or change in regulatory
  practice).
• 3. decision
• is a legislative act that applies to a specific
  member state, company or citizen.
• 4. 5. Recommendations and opinions
• These are not legally binding, but can influence
  behaviour of, for example, the European
  Commission, national regulators, etc.

42
Institutions The Big-5

• There are dozens of EU institutions
• but only 5 are really important
• European Council
• Council of Ministers
• Commission
• Parliament
• EU Court
• Others matter in specific areas or at particular
  moments

43
Institutions European Council

• consists of the leader (prime minister or
  president) of each EU member plus the President
  of the European Commission.
• by far the most influential institution
• its members are the leaders of their respective
  nations.
• provides broad guidelines for EU policy
• thrashes out compromises on sensitive issues,
  e.g.
• reforms of the major EU policies,
• the EUs multiyear budget plan,
• Treaty changes,
• final terms of enlargements, etc.

44
Institutions European Council

• meets at least twice a year (June and December)
• meets more frequently when the EU faces major
  political problems.
• highest profile meetings at the end of each
  six-month term of the EU Presidency.
• These meetings are important political and media
  events
• determine all of the EUs major moves.
• most important decisions of each Presidency are
  contained in a document, known as the
  Conclusions of the Presidency, or just the
  Conclusions

45
Institutions European Council

• Strangely, European Council has no formal role in
  EU law-making
• Its political decisions must be translated into
  action via Treaty changes or secondary
  legislation.
• Confusingly, the European Council and the Council
  of the EU are often both called the Council
• The Constitution proposes to make the European
  Council a form part of the EU institutional
  structure

46
The Triangle of EU Decision Making
Commission
EU
supranationalism
inter-governmentalism
European Parliament
Council of Ministers
Citizens
Member States
47
Institutions Council of Ministers

• Usually called by old name Council of Ministers
• formal name is now Council of the EU
• Consists representatives at ministerial level
  from each Member State, empowered to commit
  his/her Government
• Typically minister for relevant area
• e.g, Finance ministers on budget issues,
• Confusingly, Council uses different names
  according to the issue discussed.
• Famous ones include EcoFin (for financial and
  budget issues), the Agriculture Council (for CAP
  issues), General Affairs Council (foreign policy
  issues).

48
Institutions Council of Ministers

• Is EUs main decision-making body
• Almost every EU legislation must be approved by
  it
• main task to adopt new EU laws, e.g.
• measures necessary to implement the Treaties
• also measures concerning the EU budget and
  international agreements involving the EU.
• is also supposed to coordinate the general
  economic policies of the Member States in the
  context of the Economic and Monetary Union (EMU)
• e.g. famous 3 deficit rule

49
Institutions Council of Ministers

• Council also decides on
• 2nd and 3rd pillar issue, i.e. Common Foreign and
  Security Policies (2nd), police and judicial
  cooperation in criminal matters (3rd).
• two main decision-making rules.
• On the most important issues, unanimity
• e.g. Treaty changes, enlargement, multi-year
  budget plan, Council decisions are by.
• On most issues (about 80 of all Council
  decisions), majority voting
• qualified majority voting (QMV).

50
The Triangle of EU Decision Making
Commission
EU
supranationalism
inter-governmentalism
European Parliament
Council of Ministers
Citizens
Member States
51
Institutions QMV

• QMV is complex and is changing
• Four sets of rules
• 1. Procedure that applied until 1 May 2004
• Basic form unchanged since 1958 Treaty of Rome
• 2. Temporary procedure 1 May 31 Oct 2004
• Extrapolation of the pre-enlargement procedure
• 3. The Nice procedure 1 Nov 2004 31 Oct 2009
• Political agreement in Nice Treaty implemented
  by Accession Treaty for 2004 enlargement
• 4. Procedure from Constitutional Treaty 1 Nov
  2009 -
• Political agreement in the European Council at
  June 2004 meeting

52
Institutions QMV

• Procedure that applied until 1 May 2004
• Each members minister casts a certain number of
  votes
• more populous members have more votes,
• many fewer than population-proportionality
  suggests
• e.g. France (60 million citizens) has 10 votes
  Denmark (5 million citizens) has 3
• Total number of votes in the EU15 is 87.
• The threshold for a winning majority is 62 votes
• This is called a qualified majority,.
• i.e. the majority rule is that about 71 of all
  votes are required to adopt a proposal.

53
Institutions QMV

• The implications of this system are complex.
• Since bigger members have more votes, 71 of the
  votes does not mean 71 of members.
• Three large members voting no could block
  adoption even if the other 12 voted yes.
• Since small nations get far more votes than
  strict population-proportionality would suggest,
  71 of the votes does not mean 71 of the EU
  population.
• 71 threshold can theoretically be reached, for
  example, by a coalition of just 8 members
  representing 58 of the EU population.

54
Institutions QMV

• Even though QMV is the basis of most Council
  decisions, the Council rarely votes
• They usual decide things by consensus.
• Shadow voting
• Despite this, QMV and voting weights are
  important
• If nations know they would be outvoted, were a
  vote were to recorded, they usually join the
  consensus to be collegial.
• nations go through a mental process of shadow
  voting before deciding to join the consensus.
• figure out what the outcome would be, if a vote
  were held.
• Majority rule and votes matter to mental
  calculation

55
QMV Nice/Accession Treaty Reforms

• Reforms change QMV in 2 main ways
• (changes took effect in 1 November 2004)
• 1. makes QMV more complex 2 new criteria in
  addition to votes
• proposition passes the Council when coalition of
  yes-voters meets 3 criteria
• Votes
• 72 of the Council votes (232 votes of the 321
  Council votes in the EU25).
• number of members,
• 50 of the member states
• population.
• 62 of the EU population

56
QMV Nice/Accession Treaty Reforms

• 2. votes reallocated to favour big nations

57
QMV Nice/Accession Treaty Reforms

• To see this another way, look at increase by
  member
• Members ranked by population
• Poland, Spain are relative biggest winners
• Tiny members biggest relative losers

EU25 average 135
58
QMV draft Constitutional Treaty

• Voting rules in the Nice and Accession Treaties
  widely viewed as failing to meet the goal of
  maintaining the Councils ability to act
• European Convention (2002-2003) proposed a
  radical reform
• Embodied in 2003 draft Constitutional Treaty (CT)
• Under CT rules, qualified majority needs yes
  votes from
• member states with at least 60 EU population
• At least half members

59
Constitutional Treaty Reform 2004

• Double majority with two additional criteria
• 55 of member states
• 65 of population
• at least 15 member states
• note does not have effect in EU-28
• at least 4 member states are required for
  blocking proposals
• Comes into force 1 November 2009 if CT is ratified

60
Institutions the Commission

• European Commission is at the heart of the EUs
  institutional structure
• Driving force behind deeper and wider European
  integration.
• Has three main roles
• propose legislation to the Council and
  Parliament,
• to administer and implement EU policies
• to provide surveillance and enforcement of EU law
• guardian of the Treaties
• ALSO, represents EU at some international
  negotiations

61
Commissioners, Commissions composition

• Before the 2004 enlargement
• one Commissioner from each member
• extra Commissioner from the big-5 (Germany, UK,
  France, Italy and Spain in the EU15).
• Nice Treaty
• each member in EU25 has one Commissioner
• Constitutional Treaty
• The Commission of 2010-2014 has 25/27 members
• After 2014 the number of Commissioners is 2/3 of
  membership
• rotating evenly among all members

62
Commissioners, Commissions composition

• Commissioners are chosen by their own national
  governments
• subject to political agreement by other members.
• Commission, the Commission President
  individually, approved by Parliament.
• Commissioners are not national representatives.
• should not accept or seek instruction from their
  country.
• appointed together, serve for five years
• current Commissions term ends in Jan 2005.
• Each Commissioner in charge of a specific area of
  EU policy
• Directorate-Generals or DGs

63
Commissioners, Commissions composition

• Executive powers
• Commission executive in all of the EUs
  endeavours,
• power most obvious in competition policy and
  trade policy
• Manage the EU budget, subject to EU Court of
  Auditors.
• Decision making
• Decides on basis of a simple majority, if vote
  taken
• almost all decisions on consensus basis

64
Institutions European Parliament

• Two main tasks
• oversees EU institutions, especially Commission
• it shares legislative powers, including budgetary
  power, with the Council and the Commission
• Organisation
• Up till the 2004 enlargement, 626 members (MEPs)
• After enlargement 732.
• Directly elected in special elections organized
  by member nation.
• number per nation varies with population but
  rises less than proportionally.

65
Seats in the EP in 2004-09
Luxembourg 6 Hungary 24 Malta 5 Netherlands
27 Austria 18 Poland 54 Portugal 24 Slovenia
7 Slovakia 14 Finland 14 Sweden 19 United Kingdom
78
Belgium 24 Czech Republic 24 Denmark 14 Germany
99 Estonia 6 Greece 24 Spain 54 France 78 Ireland
13 Italy 78 Cyprus 6 Latvia 9 Lithuania 13
66
Institutions European Parliament

• Democratic control
• Parliament and Council are the primary democratic
  controls over the EUs activities.
• MEPs directly elected so in principle a way for
  Europeans to have a voices
• In practice, however, European Parliamentary
  elections dominated by standard
  left-versus-right, and purely local issues rather
  than by EU issues.
• The 2004 draft Constitutional Treaty proposes few
  changes for the Parliament
• Does expand its power, giving it equal standing
  with the Council on almost legislation.
• Maximum number of MEPs will be 750
• at most 96 seats for a single member state

67
Institutions European Court of Justice

• EU laws and decisions open to interpretation that
  lead to disputes that cannot be settled by
  negotiation.
• Court settle these disputes, especially disputes
  between Member States, between the EU and Member
  States, between EU institutions, and between
  individuals and the EU.
• EU Courts supranational power highly unusual in
  international organisations.
• As a result of this power, the Court has had a
  major impact on European integration.

68
Institutions European Court of Justice

• Influence
• Court has had a major impact on European
  integration via case-law
• Organisation
• located in Luxembourg
• one judge from each member
• appointed by common for six years
• also eight advocates-general to help judges
• The Court reaches its decisions by majority
  voting.
• Court of First Instance set up 1980s to help with
  ever growing workload.

69
Is the allocation among the EU states fair?
How to define the EU?

• As a state
• Each person should be treated equally
• OPOV principle

• As an association of states
• Each country should be treated equally

Laruelle and Widgrén, 1998, in Public Choice
70
EU Council as a two-tier system
The Council
Country2
Country3
Country1
How to implement the OPOV principle?
71
The square-root rule

• Lionel Penrose (1946)
• To implement the OPOV principle in a federation
  the power of the states at the upper level of
  decision-making should be proportional to their
  square-rooted population
• Note the rule is defined for the Banzhaf index,
  not for voting weights

72
Laruelle Widgrén results

• Take the EU as a convex combination of the OPOV
  principle and an association and compare the
  actual Banzhaf indices to the fair ones
• Whether a country is over- or under-represented
  compared to the fair allocation of power depends
  on the definition (with an exception of the
  Netherlands)
• The more weight is put to the association the
  more big countries are over-represented
• The more weight is put to the OPOV the more small
  countries are over-represented

73
Revealed definition of the EU

• Trying to find which combination explains the
  current power indices the best, i.e.
• NBI a(SQR) (1/15)(1-a)
• In the EU15 using current weights
• NBI 0.79(SQR) 0.21(1/15)
• In the EU27 using Nice weights
• NBI 0.92(SQR) 0.08(1/15)
• In the U.S. Congress
• NBI 0.99(SQR) 0.01(1/50)
• Giscard
• NBI 1.15(SQR) - 0.15(1/27)

74
Dual majority problem
75
The difference between the OPOV principle and
actual power scores
76
Consultation procedures
a) Majority version
b) Unanimity version
x
x
0
0
yes
yes
unanimity
x
x
x
x
unanimity
unanimity
0
0
1
1
EC
CM
EC
CM
no
no
no
no
0
0
0
0
EC European Commission
CM Council of Ministers
77
Co-decision procedure
x
x
x
x
x
x
x
x
x
3
4
5
6
4
5
6
3
3
yes
yes
yes
yes
yes
CM
no
x
x
CM
CM
CM
EP
EP
x
x
x
x
2
1
x
x
x
x
7
7
5
6
5
6
4
4
yes
yes
yes
no
no
no
no
no
no
no
no
EP
CM
0
0
0
0
0
0
0
0
EC
x
x
x
x
0
3
1
2
EP
EC
no
yes
yes
yes
yes
no
no
0
0
CM
CM
CM
EP
EP
x
x
x
x
x
x
x
x
no
5
6
7
5
6
7
4
4
CM
EC European Commission
no
no
CM Council of Ministers
no
no
no
no
no
no
yes
EP European Parliament
0
0
0
0
0
0
x
0
0
unanimity
3
CC Conciliation Committee
CC
78
3. Microeconomics
79
Preliminaries

• Introduction to Open Economy Supply Demand
  Analysis
• Start with Import Demand Curve
• This tells us how much a nation would import for
  any given domestic price
• Presumes imports and domestic production are
  perfect substitutes
• Imports equal gap between domestic consumption
  and domestic production

80
Import demand curve (MD)
Home Supply
price
price
1
P
2
P
P
3
P
P
Home import demand curve, MDH
Home Demand
quantity
imports
Z
C
Z
C
M
M
81
Import supply curve (MS)
82
Welfare Import demand curve
83
Welfare Import supply curve
84
MFN Tariff Analysis

• New equilibrium in Home (MDMS with T) is with P
  and M
• Domestic price now differs from border price
  (price exporters receive)
• P vs P-T

Border price
Domestic price
MS with T
MS
XSMS
P
PFT
PFT
T
P-T
MD
Foreign exports
Home imports
M
MFT
XM
XFT MFT
85
Positive effects

• Domestic price rises
• Border price falls
• Imports fall
• Cant see in diagram
• Domestic consumption falls
• domestic production rises
• Foreign consumption rises
• Foreign production falls
• Could get this in diagram by adding open economy
  S D diagram to right

86
Welfare effects Home

• Drop in imports creates loss equal area C
• (Trade volume effect)
• Drop in border price creates gain equal to area B
• (Border price effect)
• Net effect on Home -CB
• ALTERNATIVELY
• Private surplus change (sum of change in producer
  and consumer surplus) equal to minus AC
• Increase in tariff revenue equal to AB
• Same net effect, B-C (but less intuition)

87
Welfare effects Foreign

• Drop in exports creates loss equal area D
• (Trade volume effect)
• Drop in border price creates loss equal to area B
• (Border price effect)
• Net effect on Foreign -D-B
• ALTERNATIVELY
• Private surplus change (sum of change in producer
  and consumer surplus) equal to minus -D-B
• Same net effect, B-C (but less intuition)

88
Welfare effects useful compression

• In cases of more complex policy changes useful to
  do Home and Foreign welfare changes in one
  diagram
• MS-MD diagram allows this
• Home net welfare change is CB
• Foreign net welfare change is D-B
• World welfare change is D-C
• NB if Home gains (-CBgt0) it is because it
  exploits foreigners by making them to pay part
  of the tariff (i.e. area B)
• Notice similarity with standard tax analysis

89
Distributional consequences Home

• Trade protection imposed mainly due to
  politically considerations raised by
  distributional consequences
• Thus important for some purposes to see domestic
  consequences of trade policy change
• For this, add the open economy supply demand
  diagram to the right of the MD-MS diagram
• MD-MS diagram tells us the price and quantity
  effects of trade policy change
• Open-economy SD tells us the domestic
  distributional consequences

90
Distributional consequences Home

• Home consumers lose, area EC2AC1 Home
  producers gain E, Home tariff revenue rises by
  AB
• net change B-C2-C1 (this equals B-C in left
  panel)

91
A typology for trade barriers

• Many ways to categorise trade barriers
• A useful 3-way categorisation
• Focuses on rents i.e. who earns the gap between
  domestic and border price?
• DCR (domestically captured rents)
• FCR (foreign captured rents)
• Frictional (no rents since barriers involve real
  costs of importing/exporting)

92
A typology for trade barriers

• Net Home welfare changes for
• DCR B-C
• FCR -A-C
• Frictional -A-C
• Net Foreign welfare changes for
• DCR -B-D
• FCR A-D
• Frictional -B-D
• Note foreign may gain from FCR

euros
MS
P
A
C
PFT
D
B
P-T
MD
MFT
Home imports
M
93
Quantity changes supply switching

• RoW exports fall
• Partner exports rise more than RoW exports fall,
  so
• domestic imports rise

94
Impact of customs union formation
95
Welfare effects

• Homes net change AB-C
• Partners net change D
• RoWs net change -E

96
Analysis of a Customs Union

• European integration involved a sequence
  preferential liberalisations but all of these
  were reciprocal
• In example, both Home Partner drop T on each
  others exports
• Need to address the 3-nation trade pattern

97
Analysis of a Customs Union

• FTA vs Customs Unions
• Given symmetry 3-nation set up, FTA between Home
  and Partner is automatically a customs union
• Home-Partner CU has Common External Tariff (CET)
  equal to T
• in the real world, things are more complicated
• Analysis is simply a matter of recombining
  results from the unilateral preferential case
• In market for good 1, analysis is identical
• In market for good 2, Home plays the role of
  Partner
• In market for good 2, Partner plays role of Home

98
Welfare effects of a customs union

• In market for good 1
• Home change AB-C1-C2
• In market for good 2
• Home change D1D2
• NB D1C1
• Net Home impact AB-C2
• Partner impact identical
• RoW loses

M
99
Welfare effects of regional integration trade
creation and trade diversion

• consumers abcd
• producers -a
• government -c-e
• --------------------------
• Total bd-e

pt
a
c
b
d
p
e
p
imports in EU
pre-membership imports
D
D
S
S
100
Customs Union vs FTA

• FTA like CU but no Common External Tariff
• Opens door to tariff cheats,
• goods from RoW destined for Home market enter via
  Partner if Partner has lower external tariff,
  called trade deflection
• Solution is rules of origin meant to establish
  where a good was made.
• Problems Difficult and expensive to administer,
  especially as world get more integrated
• Rules often become vehicle for disguised
  protection
• Despite the origin-problem in FTAs, almost all
  preferential trade arrangements in world are
  FTAs.
• CUs require some political integration
• Must agree on CET and how to change it, including
  anti-dumping duties, etc.

101
WTO Rules

• A basic principle of the WTO/GATT is
  non-discrimination in application of tariffs
• FTAs and CUs violate this principle
• Article 24 permits FTAs and CUs subject to
  conditions
• Substantially all trade must be covered
• Cannot pick and choose products
• Intra-bloc tariffs must go to zero within
  reasonable period
• If CU, the CET must not on average be higher than
  the external tariffs of the CU members were
  before
• In EECs CU this meant France and Italy lowered
  their tariffs, Benelux nations raised theirs
  (German tariffs were about at the average anyway)

102
Kemp-Wan Theorem
XPt0
XWt0
a
XP
XPXWtU
PH
XW
b
a
b
c
PU
PH-t0
e
d
f
XP
XW
M0
M1
H c-d, P de gt unambigously positive welfare
effect
103
Market Size Matters

• European leaders always viewed integration as
  compensating small size of European nations
• Implicit assumption market size good for
  economic performance
• Facts integration associated with mergers,
  acquisitions, etc.
• In Europe and more generally, globalisation

104
Facts

• MA activity is high in EU
• much MA is mergers within member state
• about 55 domestic
• Remaining 45 split between
• one is non-EU firm (24),
• one firm was located in another EU nation (15)
• counterpartys nationality was not identified
  (6).

105
Facts

• Distribution of MA quite varied
• big 4 share MAs much lower than share of the EU
  GDP.
• I, F, D 36 of the MAs, 59 GDP.
• Except UK
• small members have disproportionate share of MA.

106
Economic Logic Verbally

• liberalisation ?
• de-fragmentation ?
• pro-competitive effect ?
• industrial restructuring (MA, etc.)
• RESULT fewer, bigger, more efficient firms
  facing more effective competition from each other

107
Economic logic background

• Monopoly case

Demand Curve
Marginal Revenue Curve
Price
Price
Demand Curve
Marginal Cost Curve
P
P
A
P
B
D
Marginal Cost
C
E
Q
Q
Sales
Sales
Q1
108
Economic logic background

• Duopoly case, example of non-equilibrium

price
price
Firm 1s expectation of sales by firm 2, Q2
Firm 2s expectation of sales by firm 1, Q1
Demand Curve (D)
Demand Curve (D)
p1
p2
Residual Demand Curve firm 1 (RD1)
Residual Demand Curve firm 2 (RD2)
MC
MC
A1
A2
x2
x1
Firm 2 sales
Firm 1 sales
Residual Marginal Revenue Curve firm 2 (RMR2)
Residual Marginal Revenue Curve firm 1 (RMR1)
109
Economic logic background

• Duopoly oligopoly case, equilibrium outcome

price
price
Typical firms expectation of the other firms
sales
Typical firms expectation of the other firms
sales
p
D
D
p
RD
RD
MC
A
MC
A
RMR
RMR
sales
sales
x
x
2x
3x
Oligopoly
Duopoly
110
BE-COMP diagram
111
Details of COMP curve
Mark-up
price
mmono
p'
A
p"
mduo
B
D
Monopoly mark-up
Duopoly mark-up
COMP curve
R-D (duopoly)
Marginal cost curve
MC
A
B
Number of firms
n1
n2
R-MR
MR (monopoly)
Typical firms sales
xmono
xduo
112
Details of BE curve
Mark-up (i.e., p-MC)
euros
price
Home market
pomoMC
BE
Demand curve
A
ACgtpo
ACopo
B
A
po
mo
B
ACltpo
AC
MC
Number of firms
no
n
n
Sales per firm
Total sales
Co
x Co/n
x Co/n
xo Co/no
113
Equilibrium in BE-COMP diagram
Price
Mark-up
euros
Home market
Demand curve
BE
E
E
E
m'
p
p
AC
COMP
MC
Number of firms
n
Sales per firm
Total sales
x
C
114
No-trade-to-free-trade integration
price
Mark-up
euros
Home market only
Demand curve
BE
BEFT
E
1
E
E
m'
p
p
E
C
E
E
p
p
A
A
pA
mA
AC
COMP
MC
Number of firms
2n
n
n
Sales per firm
x
Total sales
C
C
x
115
Economic Logic

• Integration no-trade-to-free-trade BE curve
  shifts out (to point 1)
• Defragmentation
• PRE typical firm has 100 sales at home, 0
  abroad POST 50-50
• Cant see in diagram
• Pro-competitive effect
• Equilibrium moves from E to A Firms losing
  money (below BE)
• Pro-competitive effect markup falls
• short-run price impact p to pA
• Industrial Restructuring
• A to E
• number of firms, 2n to n.
• firms enlarge market shares and output,
• More efficient firms, AC falls from p to p,
• mark-up rises,
• profitability is restored
• Result
• bigger, fewer, more efficient firms facing more
  effective competition
• Welfare gain is C

116
Pro-competitive effect
Y
p
p
T
F
a
c
b
AC
AC
X
T
X
X
117
Love of variety
Y
T
F
C
A
F
T
X
118
Growth Effects

• European leaders have long emphasised a different
  the pro-growth aspects of European integration
• These operate in a way that is fundamentally
  different from the way allocation effects
  operate
• they operate by changing the rate at which new
  factors of production mainly capital are
  accumulated,
• hence the name accumulation effects.

119
Verbal logic of growth

• Growth in income per worker requires more output
  per worker
• Nation's labour force can produce more goods and
  services year after year only if they have
  more/better 'tools' year after year.
• 'tools' means capital broadly defined
• physical capital (machines, etc.),
• human capital (skills, training, experience,
  etc.) and
• knowledge capital (technology).
• ERGO, rate of output growth linked to rate of
  physical, human and knowledge capital
  accumulation.
• Most capital accumulation is intentional and it
  is called investment.
• Thus European integration affects growth mainly
  via its effect on investment in human capital,
  physical capital and knowledge capital.

120
Verbal logic of growth summary

• European integration (or any other policy) ?
  allocation effect ? improved efficiency ?
  better investment climate ? more investment in
  machines, skills and/or technology ? higher
  output per person.
• Medium run effects eventually peter out
• Growth returns to its long-run rate
• Long run effects raise long-run rate forever

121
Induced capital formation
Induced capital formation effect, i.e. medium-run
growth bonus
euros/L
GDP/L
E
Y/L
C
GDP/L
Y/Lc
Allocation effect
Y/L
d(K/L)
B
s(GDP/L)
D
s(GDP/L)
A
K/L
K/L
K/L
122
Long-term growth impact of integration
Integration improves efficiency ? improves
investment climate ? higher investment rate (s
rises to s) ? faster growth (knowledge capital
accumulates more rapidly)
euros/L
GDP/L
s(GDP/L)
Y/L
s(GDP/L)
C
A
d(K/L)
B
K/L
K/L Knowledge/L
123
Geographic income inequality

• income distribution even more uneven at regional
  level.
• Within nation economic activity is very unevenly
  distributed
• Income distribution has become
• More even in EU15
• Less even within EU15 nations (by region)

124
Geographic Specialisation

• Krugman index of specialisation shows most EU
  nations becoming more specialised
• EU economies seem to be specialising more in
  their comparative advantages

125
Theory

• 2 major approaches linking economic integration
  to change in the geographic location of economic
  activity
• Comparative advantage suggests nations specialise
  in sectors in which they have a comparative
  advantage
• New Economic Geography suggests that integration
  tends to concentrate economic activity spatially
• General idea
• Use c.a. approach to explain cross-nation facts
• Use NEG to explain within nation facts

126
Agglomeration NEG

• When productive factors can cross borders
  (international or inter-regional) integration may
  have very different effects
• scale economies trade costs generate forces
  that encourage geographic clustering of economic
  activity.
• "Overall clustering some areas with lots of
  economic activity, others empty core-periphery
• "Sectoral clustering" each sector clusters in
  one region, but most regions get a cluster

127
Agglomeration Dispersion Forces

• Basic idea is that lowering trade costs affect
  both
• Agglomeration forces
• Tend to lead industry to cluster geographically
• Dispersion forces
• Tend to encourage industry to disperse
  geographically

128
Agglomeration Forces

• Many agglomeration forces
• Technological spillovers (e.g. silicon valley)
• Labour market pooling (e.g. City of London)
• Demand linkages (backward linkages)
• Supply linkages (forward linkages)
• NEG forces on demand supply links since they
  are clearly affected by economic integration
  (lower trade costs)

129
Circular Causality Demand Linkages
1. If some industry moves to big region
4. Production Shifting, Due to trade costs,
firms prefer to locate in big market. More
industry moves to big region
2. Expenditure Shifting, workers spend incomes in
big region instead of in small region
3. Market Size Effects big market gets bigger,
small market gets smaller
130
Circular Causality Supply Linkages
1. If some industry moves to big region
4. Production Shifting Some more firms move from
small market to big market, attracted by lower
costs
2. Production Shifting, Migrated firms output
now cheaper in big region dearer in small
region (trade costs)

• 3. Cost Shifting,
• Availability of wider range of locally available
  intermediate goods makes big region cheaper place
  to produce

131
Dispersion Forces

• Many forces lead to a tendency of firms to avoid
  agglomerations of economic activity
• Rents and land prices
• High cost of other non-traded services
• Competition with other firms
• The NEG focuses on the last one local
  competition since it is clearly related to trade
  costs
• As trade costs fall, distance provides less
  protection from distant competitors

132
EE-KK Diagram

• Study impact of integration on geographical
  concentration in EE-KK diagram
• Simplifying assumptions
• Only 2 regions, north and south
• 2 factors, capital (mobile), labour (immobile)
• 2 sectors, services (L-intensive), industry
  (K-intensive)
• Assume one unit of K required per industrial firm
• Implies norths share of K is also its share of
  industry

133
EE Curve

• EE curve shows demand linkage
• EE upward sloped as north gets a larger share of
  industry its market becomes larger relative to
  that of the south.
• EE steeper than 45o the mobile factor makes up
  only part of total expenditure.
• For EE line, trade costs dont matter
• What matters is how much labour and how much
  capital is in each region.
• As norths labour share rises, EE shifts to right

134
KK Curve

• KK is upward sloped
• steeper than 45o (home market effect)
• trade costs level affects the KK curve.
• trade costs ?, KK gets steeper
• share of labour in the two regions has no impact
  on KK.

135
EE-KK Diagram locational equilibrium

• KK shows how production shifting leads to
  expenditure shifting
• EE shows how expenditure shifting leads to
  production shifting
• Intersection of EE and KK show equilibrium sK and
  sE.
• If economy starts elsewhere, say A, expenditure
  and production shifting move it to B

136
EE-KK Diagram locational equilibrium

• European integration lowers trade costs
• KK rotates counter clockwise around ½,½
• More industry moves to the bigger market
• B to B
• Explains tendency of integration to foster
  geographic clustering of economic activity
• Can be all industry (empty out some regions)
• Can be clusters by sector

137
A good question, no simple answer

• Should curreny area borders coincide with
  national borders?
• If not, how best to delineate currency areas?
• What economic criteria should be used?

138
In a nutshell

• The benefits
• Money exhibits increasing returns to scale
  (network externalities)
• The world is the way to maximize these benefits
• The costs
• Loss of monetary and exchange rate instruments
• Matters in presence of
• Price and wage stickiness
• Asymmetric shocks

139
Criterion 1 (Mundell) Labour mobility

• In an OCA labour moves easily across national
  borders
• Caveats
• Labour mobility is easy within national borders
  (culture, language, legislation, welfare, etc)
• Capital mobility difference between financial
  and physical capital
• Ini presence of country specialization, skills
  also matter

140
Criterion 2 (Kenen) Production diversification

• Countries whose production and exports are widely
  diversified and of similar structure form an OCA
• Indeed, in that case, there are few asymmetric
  shocks and each of them is likely to be of small
  concern

141
Criterion 3 (McKinnon) Openness

• Countries which are very open to trade and trade
  heavily with each other form an OCA
• Distinguish between traded and nontraded goods
• Traded good prices are set worldwide
• A small economy is price-taker, so the exchange
  rate does not affect competitiveness
• In the limit, if all goods are traded, domestic
  good prices must be flexible and the exchange
  rate does not matter for competitiveness

142
Criterion 4 Fiscal transfers

• Countries that agree to compensate each other for
  adverse shock form an OCA
• Transfers can act as an insurance that mitigates
  the costs of an asymmetric shock
• Transfers exist within national borders
• Implicitly through the welfare system
• Explicitly in federal states

143
Criterion 5 Homogeneous preferences

• Countries that share a wide consensus on the way
  to deal with shocks form an OCA
• Matters primarily for symmetric shocks
• Prevalent when the Kenen criterion is satisfied
• May also help for asymmetric shocks
• Better understanding of partners actions
• Encourages transfers

144
Criterion 6 Commonality of destiny

• Countries that view themselves as sharing a
  common destiny better accept the costs of
  operating an OCA
• A common currency will always face occasional
  asymmetric shocks that result in temporary
  conflicts of interests
• This calls for accepting such economic costs in
  the name of a higher purpose

145
History never ends the endogeneity of OCA
criteria

• Living in a monetary union may help fulfill the
  OCA criteria over time
• Would the US be an OCA without a single common
  currency?
• Will the existence of the euro area change
  matters too ?

146
Will trade deepen?

• Little evidence thta reducing exchange rate
  volatiliy increases trade
• Mounting evidence that eliminating exchange rate
  volatility by adopting a common currency raises
  trade a lot
• Estimates range from 50 to 100
• The border effect provides similar estimates

147
Will diversification grow or decline?

• Argument 1 intra-industry trade will grow
• Argument 2 specialization will increase
• No firm conclusion so far

148
EMU and labour markets

• Mobility may not change much, but wages could
  become less sticky
• Two views
• The virtuous circle labour markets respond to
  enhanced competition by becoming more flexible
• The hardening view labour markets respond to
  enhanced competition by increasing protective
  measures that raise stickiness
• The jury is still out

149
Are the other criteria endogenous?

• Transfers
• Currently no support for more taxes fo finance
  transfers
• Homogeneity of preferences
• No presumption that it will change soon
• Commonality of destiny
• No presumption that it will change soon

150
In the end

• Monetary union is not only about economics
• The OCA criteria do not send a clear signal
• The EU is not a perfect OCA
• A monetary union may function, at cost
• The OCA criteria tell us where the costs will
  arise
• Labour markets and unemployment
• Political tensions in presence of deep asymmetric
  shocks